Learning Objectives. After reading Chapter 11 and working the problems for Chapter 11 in the textbook and in this Workbook, you should be able to:

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1 Learning Objectives After reading Chapter 11 and working the problems for Chapter 11 in the textbook and in this Workbook, you should be able to: Discuss three characteristics of perfectly competitive markets. Apply the basic principles of marginal analysis to determine either (1) the profitmaximizing (or loss-minimizing) level of output, or (2) the profit-maximizing (or loss-minimizing) level of input usage. Explain why the demand curve facing an individual firm in a perfectly competitive industry is perfectly elastic, and why this demand curve is also the marginal revenue curve for a competitive firm. Explain why a firm should shut down in the short run if market price falls below minimum average variable cost. Calculate profit margin (or average profit) and explain why profit margin should be ignored when making profit-maximizing decisions. Explain why fixed costs are irrelevant to a manager s production decision. Define the concept of long-run competitive equilibrium and explain why a firm in long-run competitive equilibrium produces at the minimum point on long-run average cost. Give a definition of increasing cost and constant cost industries and draw a longrun industry supply curve for a constant cost industry and for an increasing cost industry. Explain, using the concept of economic rent, why it is possible for owners of exceptionally productive resources to get rich even though economic profit is zero in the long run for competitive markets. Find the profit-maximizing (or loss-minimizing) level of output for a firm operating in a perfectly competitive market using empirical estimates (or forecasts) of (1) the market price of the commodity, (2) the average variable cost function, and (3) the marginal cost function. 220

2 Essential Concepts 1. Perfect competition occurs when a market possesses the following three characteristics: i. Firms are price-takers because each firm produces only a very small portion of total market or industry output. ii. All firms in the market produce a homogeneous or perfectly standardized product. iii. Entry into and exit from the market is unrestricted. 2. The demand curve facing a competitive price-taking firm is horizontal or perfectly elastic at the price determined by the intersection of the market demand and supply curves. Since marginal revenue equals price for a competitive firm, the demand curve is also simultaneously the marginal revenue curve (i.e., D = MR). Pricetaking firms can sell all they want at the market price. Each additional unit of sales adds to total revenue an amount equal to price. Profit Maximization in the Short Run: 3. In the short run, the firm incurs fixed costs that are unavoidable i.e., they must be paid even if output is zero and variable costs that can be avoided if the firm chooses to shut down. 4. Shut down refers to the decision in the short run to produce zero output, which means the manager hires n variable inputs. The only costs incurred during shut down are the unavoidable fixed costs. 5. A manager makes two decisions in the short run: (1) whether to produce or shut down, and (2) if the decision is to produce, how much to produce. 6. In making the decision to produce or shut down, the manager will consider only the (avoidable) variable costs and will ignore fixed costs. 7. Profit margin is the difference between price and average total cost, which is equal to average profit (or profit per unit), as long as every unit is sold for the same price: Average profit = π Q (P ATC)Q = Q = P ATC = Profit margin 8. The output level that maximizes profit margin is not the output level that maximizes profit. For this reason, managers should ignore profit margin or profit per unit when making their production decisions. See Figure 11.3 in the textbook for a numerical example that shows why it is a mistake to maximize profit margin. 9. Break-even points are the output levels there are usually two of these points where price equals average total cost, and thus profit equals zero at these points. 221

3 10. In the short run, the manager of a firm will choose to produce the output where P = SMC, rather than shut down, as long as total revenue is greater than or equal to the firm s total avoidable cost or total variable cost (TR TVC ). Or, equivalently, a firm should produce as long as price is greater than or equal to average variable cost ( P AVC ). If total revenue cannot cover total avoidable cost, that is, if total revenue is less than total variable cost (or equivalently, P < AVC), the manager will shut down and produce nothing, losing an amount equal to total fixed costs. 11. Fixed costs are irrelevant in the production decision because the level of fixed cost has no effect on either marginal cost or minimum average variable cost, and thus no effect on the optimal level of output. 12. Sunk costs are irrelevant in the production decision because such costs are forever unrecoverable, no matter what output decision is made, and so sunk costs cannot affect current or future decisions. 13. Average costs are also irrelevant for production decisions. Only marginal cost matters when finding the positive amount of output that maximizes profit. Technical note: AVC is not employed to find the optimal output, but rather to make sure the optimal output is not zero (i.e, whether to shut down or not). 14. Summary of the manager's output decision in the short-run: i. Average variable cost tells whether to produce; the firm ceases to produce shuts down if price falls below minimum AVC. ii. iii. Marginal cost tells how much to produce; if P minimum AVC, the firm produces the output at which P = SMC. Average total cost tells how much profit or loss is made if the firm decides to produce; profit equals the difference between P and ATC multiplied by the quantity produced and sold. 15. The short-run supply curve for an individual price-taking firm is the portion of the firm s marginal cost curve above minimum average variable cost. For market prices less than minimum average variable cost, quantity supplied is zero. 16. The short-run supply curve for a competitive industry can be obtained by horizontally summing the supply curves of all the individual firms in the industry. Shortrun industry supply is always upward-sloping, and supply prices along the industry supply curve give the marginal costs of production for every firm contributing to industry supply. 17. Short-run producer surplus is the amount by which total revenue exceeds total variable cost and equals the area above the short-run supply curve below market price over the range of output supplied. Short-run producer surplus exceeds economic profit by the amount of total fixed costs. Profit Maximization in the Long Run: 18. In long-run competitive equilibrium, all firms are in profit-maximizing equilibrium (P = LMC). Long-run competitive equilibrium occurs because of the entry of new firms into the industry or the exit of existing firms from the industry. The market adjusts so that P = LMC = LAC, which is at the minimum point on LAC. 222

4 19. The long-run industry supply curve can be either flat (perfectly elastic) or upward sloping depending upon whether the industry is a constant cost industry or an increasing cost industry, respectively. a. For a constant cost industry, as industry output expands, input prices remain constant, and the minimum point on LAC is unchanged. Since long-run supply price equals minimum LAC, the long-run industry supply curve is perfectly elastic (horizontal). b. For an increasing cost industry, as industry output expands, input prices are bid up, causing the minimum point on LAC to rise, and long-run supply price to rise. The long-run industry supply curve for an increasing cost industry is upward sloping. 20. For both constant-cost and increasing-cost industries, long-run industry supply curves give supply prices for various levels of industry output allowing the industry to reach long-run competitive equilibrium. Thus, economic profit for every firm in the industry is zero at all points on the long-run industry supply. Furthermore, long-run supply prices give both LAC min and LMC for all firms in the industry. 21. Economic rent is a payment to the owner of a scarce, superior resource in excess of the resource s opportunity cost. Firms that employ such exceptionally productive resources earn only a normal profit (economic profit is zero) in long-run competitive equilibrium because the potential economic profit from employing a superior resource is paid to the resource as rent. 22. As noted above, firms that employ exceptionally productive, superior resources earn zero economic profit in long-run competitive equilibrium. In increasing industries, all long-run producer surplus is paid to resource suppliers as economic rent. And, of course, for constant-cost industries there is zero producer surplus (and zero rent) since industry supply is perfectly horizontal. Profit-Maximizing Input Usage: 23. Choosing either output or input usage to maximize profit leads to the same maximum profit level. The profit-maximizing level of input usage produces exactly that level of output that maximizes profit. a. The marginal revenue product (MRP) of an additional unit of a variable input is the additional revenue from hiring one more unit of the input. For the variable input labor: ΔTR MRP = = P MP ΔL When a manager chooses to produce rather than shut down (TR > TVC), the optimal level of input usage is found by following this rule: If the marginal revenue product of an additional unit of the input is greater (less) than the price of the input, then that unit should (not) be hired. If the usage of the variable input varies continuously, the manager should employ the amount of the input at which MRP = input price. 223

5 b. Average revenue product (ARP) is the average revenue per worker (ARP = TR/L). ARP can be calculated as the product of price times the average product of labor: TR ARP = = P AP L A manager should shut down operation in the short-run if there is no level of input usage for which ARP is greater than or equal to MRP. When ARP is less than MRP, total revenue is less than total variable cost, and the manager minimizes losses in the short run by shutting down. Implementing the Profit-Maximizing Output Decision: 24. The following steps that use empirical estimates of price and costs can be employed to find the profit-maximizing rate of production and the level of profit a competitive firm will earn. Step 1: Forecast the price of the product. Use the statistical techniques presented in Chapter 7 to forecast the price of the product. Step 2: Estimate average variable cost (AVC) and marginal cost (SMC). The cubic specification is the appropriate form for estimating a family of short-run cost curves: 2 AVC = a + bq + cq and SMC = a + 2bQ + 3cQ Step 3: Check the shutdown rule. If P AVC min, then the manager should produce. If P < AVC min, then the manager should shut down (i.e., Q * = 0). Step 4: If P AVC min, find the output level where P = SMC. The profitmaximizing output level occurs where P = SMC. To find the optimal level of output, set forecasted price equal to estimated marginal cost and solve for Q * : Step 5: P = a + 2bQ + 3cQ * *2 Compute profit or loss. Once a manager determines how much to produce, the calculation of total profit is a straightforward matter. Profit = TR TC If = * * P Q AVC Q TFC = ( ) * P AVC Q TFC P < AVC, the firm shuts down, and profit is TFC. min 2 224

6 Matching Definitions average revenue product break-even points constant-cost industry economic rent increasing-cost industry long-run competitive equilibrium marginal revenue product perfect competition perfectly elastic demand profit margin (or average profit) quadratic formula shut down shutdown price 1. A market structure in which a large number of firms sell a homogenous product or service with no restrictions on entry or exit and each firm is a price-taker. 2. The demand facing a price-taking firm. 3. A firm produces zero output but must still pay its fixed costs. 4. Price minus average total cost. 5. Output levels where P = ATC. 6. Price below which a firm shuts down in the short run. 7. All firms produce where price equals long-run marginal cost, and economic profits are zero. 8. Industry in which input prices rise as all firms in the industry expand output. 9. Industry in which input prices remain constant as all firms in the industry expand output. 10. Payment in excess of a resource s opportunity cost. 11. The additional revenue earned by hiring one more unit of a variable input. 12 The average revenue per worker. 13. X, X 1 2 ± = 2C 2 B B 4AC 225

7 Study Problems 1. The manager of a competitive firm will: a. Produce rather than shut down if the forecasted price of the product is greater than. b. Produce and make an economic profit if the forecasted price of the product is greater than. c. Produce at a loss if the forecasted price is less than but greater than. d. Shut down if the forecasted price is less than. e. Minimize loss by producing the level of output where equals when forecasted price is greater than but less than. f. Maximize profit by producing the level of output where equals when forecasted price is greater than. 2. Answer the following questions using the cost curves for the price-taking firm shown in the figure below. a. If price is $3 per unit of output, draw the marginal revenue curve. The manager should produce units. b. Since average total cost is $ for this output, total cost is $. c. The firm makes a profit of $. 226

8 d. Let price fall to $1, and draw the new marginal revenue curve. The manager should now produce units. e. At a price of $1, total revenue is now $ and total cost is $. The firm makes a loss of $. f. At a price of $1, total variable cost is $, leaving $ to apply to fixed cost. g. If price falls below $, the firm will produce zero output. 3. If a firm is making a loss in the short run, it can do either of two things in the long run: (i) (ii) Explain the circumstances under which each of these actions will be taken. 4. In long-run competitive equilibrium, consumers pay the lowest price for each unit of the good. Explain why. 5. Consider a competitive, price-taking firm that employs only one variable input, labor, to produce a product that sells for $14 per unit. The wage rate is $24 per unit of labor and total fixed costs are $500. Fill in the blanks in each column of this table as instructed by the questions below: (1) (2) (3) (4) (5) (6) (7) (8) Units of Labor Output Marginal Marginal Revenue Average Average Revenue Marginal Cost Profit 0 0 xx xx xx xx xx 227

9 a. Fill in the blanks in columns 3 and 5. Marginal product begins to diminish beyond units of labor. Marginal product is negative for the th unit of labor. [Note: You will see later in this problem that the profitmaximizing level of labor usage does indeed occur well in the range of diminishing marginal product, but not into the range of negative marginal product.] b. Compute marginal and average revenue products and fill in the blanks in columns 4 and 6. The sixth unit of labor (increases, decreases) (total, marginal) revenue by $. Decreasing labor usage from three to two units (increases, decreases) (total, marginal) revenue by $. c. The manager can maximize total revenue by hiring units of labor. The maximum possible value of total revenue is $. d. The manager hires units of labor in order to maximize profit. At this level of labor usage, ARP = which is (greater, less) than MRP. e. Compute marginal cost and fill in the blanks in column 7. At first, marginal cost (rises, falls) as marginal product rises, then marginal cost (rises, falls) as marginal product falls. f. The profit-maximizing level of output is units because this is the last level of output for which exceeds, or equivalently, exceeds. g. Compute profit and fill in the blanks in column 8. The optimal level of labor employment and the optimal level of output both result in an identical maximum profit level of $. 6. A textile firm in a competitive industry employs a particularly efficient manager to run the operations at its production facility. In the textile industry, a plant manager typically makes a salary of $4,500 per month. The textile firm employing the superior manager faces the LAC and LMC curves shown in the figure below. In long-run competitive equilibrium, the price of the product is $9. 228

10 a. A typical textile firm in this competitive industry has a minimum long-run average cost of $. The typical textile firm earns economic profit of $. b. The textile firm with the superior plant manager could earn economic profit of $ per month, if no rent is paid to the superior manager. c. The superior plant manager is likely to earn a salary of $ per month, $ of which is economic rent. d. If the superior plant manager also owned the textile firm, she would earn $ of economic profit. Explain your answer. 7. Consider a price-taking firm in the competitive industry for raw chocolate. The market demand and supply functions for raw chocolate are estimated to be Chocolate demand: Chocolate supply: Q = 10,000 10,000P + 2M Q = 40, ,000P 4,000P I where Q is the number of 10 pound bars per month, P is the price of a 10 pound bar of raw chocolate, income is M, and P I is the price of cocoa (the primary ingredient input). The manager of ABC Cocoa s uses time-series data to obtain the following forecasted values of M and P I for 2011: M = $25,000 and P I = $10 The manager of ABC Cocoa also estimates its average variable cost function to be AVC = Q Q 2 Fixed costs at ABC will be $1,600 in a. The price of raw chocolate in 2011 is forecasted to be $. b Average variable cost reaches its minimum value at bars of chocolate per month. c. The minimum value of average variable cost is $. d. Should ABC Cocoa produce or shut down? e. The marginal cost function for the firm is SMC =. f. The optimal level of production for the firm is bars of chocolate per month. g. The maximum profit (minimum loss) that ABC can expect to earn is $. Next let forecasted price of raw chocolate fall to $1.50. h. The optimal level of production for ABC is now bars of chocolate per month. i. The profit (loss) for ABC is forecasted to be $. 229

11 8. The graphs below show cost, revenue, and profit conditions facing a price-taking firm in a competitive market that faces a market-determined price of $900 per unit. Find the values that belong in blanks a k. 230

12 9. Answer the following questions based on the figure and your answers in Study Problem 8. a. What is average fixed cost at 250 units? At 650 units? What is total fixed cost at 250 units? At 650 units? Using these values, explain how AFC and TFC are related to increases in Q. b. What are the two break-even values of output? In the top panel, construct a tangent line to TC at each one of the break-even points. At the lower breakeven point, is the tangent line steeper or flatter than TR? In the bottom panel, should MR be greater or less than SMC at the lower break-even point? Explain. What happens at the higher output where break-even occurs? c. Why is the slope of the profit function zero at the profit-maximizing level of output? d. At what level of output is profit margin or average profit maximized? How much more profit can the firm earn by producing the output where MR = MC than by producing where unit costs are minimized? e. When the manager is producing 400 units, the firm s marketing director complains that the firm should increase output to 500 units because this will increase revenues by $90,000. If you were the manager of this firm, how would you respond to this advice? Multiple Choice / True-False 1. Which of the following statements is not a characteristic of a perfectly competitive firm? a. Perfectly competitive firms view each other as fierce rivals. b. Firms are price-takers. c. All firms produce a homogeneous product. d. Perfectly competitive markets allow freedom of entry and exit. 2. Since the firm s demand curve is perfectly elastic for a price-taking firm, a. P = MR. b. P = MRP. c. P = TR. d. both a and b. e. both a and c. 3. In the short run, a firm shuts down when a. profit is negative. b. TR < TVC. c. MRP > ARP at the level of labor usage where MRP = w. d. both b and c. e. all of the above. 231

13 4. In the short run, a firm continues to produce at a loss when a. TR TFC. b. P AFC. c. (TR/Q) (ATC AFC). d. both b and c. e. both a and c. 5. In a competitive industry the market price of output is $24. A firm is producing that level of output at which average total cost is $30, marginal cost is $25, and average fixed cost is $5. In order to maximize profit (or minimize losses), the firm should a. increase output. b. decrease output but keep producing. c. leave output unchanged. d. shut down. 6. In long-run competitive equilibrium, a. economic profit is zero. b. P = LMC. c. P = LAC. d. P = SMC. e. all of the above. A firm produces good X and sells the good in a competitive market. The marketdetermined price of X is $2. Fill in the blanks in the table, and answer questions Total Units of Labor Marginal Average Marginal Revenue Average Revenue 0 0 xx xx xx xx

14 7. The marginal revenue product for the third unit of labor is. a. $18 b. $48 c. $16 d. $9 e. $36 8. At a wage rate of $22, the firm will hire a. 0 units of labor. b. 1 unit of labor. c. 3 units of labor. d. 7 units of labor. e. 8 units of labor. 9. At a wage rate of $26, the firm will hire a. 0 units of labor. b. 1 unit of labor. c. 3 units of labor. d. 6 units of labor. e. 7 units of labor. 10. At a wage rate of $40, the firm will hire a. 0 units of labor. b. 1 unit of labor. c. 3 units of labor. d. 7 units of labor. e. 8 units of labor. Use the following figure showing short-run cost curves for a competitive price-taking firm to answer questions

15 11. If price is $70 how much does the firm produce? a. 750 units b. 1,000 units c. 900 units d. 600 units 12. If price is $70 how much profit (loss) does the firm make? a. zero b. $16,500 c. $20,000 d. $23,000 e. $15, Let price be $40. How much does the firm produce? a. zero units b. 500 units c. 600 units d. 700 units e. 800 units 14. If price is $40, how much profit (loss) does the firm make? a. it loses its fixed cost b. $5,000 c. $7,000 d. $4,000 e. $3, Below what price will the firm shut down and produce nothing? a. $48 b. $18 c. $20 d. $30 e. $50 234

16 Use the following figure showing long-run cost curves for the typical firm in a perfectly competitive industry, to answer questions If price is $40, the firm will produce units. a. 2,000 b. 3,000 c. 4,000 d. 4,500 e. 5, If price is $40, how much profit (loss) does the firm make? a. $75,000 b. $60,000 c. $50,000 d. $10,000 e. zero 18. If price is $40 and the firm produces the optimal level of output in this period, what is likely to occur next period? a. Each firm will increase output. b. Price will fall. c. Firms will exit the market. d. b and c. e. all of the above. 235

17 19. If this industry is in long-run competitive equilibrium the firm will produce units of output and price will be. a. 1,000; $15 b. 2,000; $20 c. 3,000; $20 d. 4,000; $22 e. 4,500; $30 For questions 20 28, use the following data for a competitive industry and a price-taking firm that operates in this market. Using time-series data, the market demand and supply functions are estimated to be Demand: Qˆ = P M Supply: Qˆ = P 12.5P I where output is Q, the price of the product is P, income is M, and the price of a key input is P I. The income forecasted for 2012 is $30,000 and the price of inputs is $52. Jartech, Inc. is a firm operating in this market. Jartech s average variable cost function is estimated to be ˆ 2 AVC = Q Q where AVC ˆ is measured in dollars per unit. Jartech expects to face total fixed costs of $2,500 in What is the price forecast for 2012? a. $15 b. $20 c. $35 d. $40 e. $ At what output level will Jartech s average variable cost reach its minimum value? a. 200 units b. 300 units c. 400 units d. 500 units e. 600 units 22. What is the minimum average variable cost? a. $0 b. $55 c. $45 d. $44 e. $ The profit-maximizing (or loss-minimizing) output for Jartech is a. 0 units. b. 300 units. c. 400 units. d. 500 units. e. 600 units. 236

18 24. What is average variable cost at the profit-maximizing level of output? a. $0 b. $20 c. $44 d. $45 e. $ How much profit (loss) does Jartech, Inc. expect to earn? a. $2,500 b. $2,500 c. $3,000 d. $3,000 e. $2,000 In questions 26 28, suppose that the 2012 input price forecast is revised to $20 (P I = $20). 26. What is the revised price forecast for 2012? a. $15 b. $20 c. $35 d. $40 e. $ What is Jartech s profit-maximizing (or loss-minimizing) output? a. 0 units b. 300 units c. 400 units d. 500 units e. 600 units 28. Under the revised forecast how much profit (loss) does Jartech, Inc. expect to earn? a. $0 b. $2,500 c. $2,500 d. $3,000 e. $3, T F A perfectly competitive firm will continue to produce at a loss in the short run as long as total revenue covers the firm s fixed costs. 30. T F When we say fixed costs don't matter, we mean that increasing fixed costs has no effect on profit. 31. T F An increase in demand will not cause price to rise if the industry is a constant cost industry. 32. T F If firms in a competitive industry are making an economic profit, new firms will enter and both price and profit will decrease. 237

19 33. T F If the owner s superior managerial ability is keeping the firm s costs below those of other firms, the firm will earn economic profit in longrun competitive equilibrium. 34. T F If price is greater than marginal cost, the firm should produce less. Answers MATCHING DEFINITIONS 1. perfect competition 2. perfectly elastic demand 3. shut down 4. profit margin (or average profit) 5. break-even points 6. shutdown price 7. long-run competitive equilibrium 8. increasing-cost industry 9. constant-cost industry 10. economic rent 11. marginal revenue product 12. average revenue product 13. quadratic formula STUDY PROBLEMS 1. a. minimum AVC b. ATC c. ATC; minimum AVC d. minimum AVC e. P; SMC; minimum AVC; ATC f. P; SMC; ATC 2. a. 4,000 units maximizes profit b. $2; $8,000 c. profit = $4,000 d. 2,000 units to maximize profit e. TR = $1 2,000 = $2,000; TC = $1.50 2,000 = $3,000; profit = $2, 000 $3, 000 = $1, 000 f. TVC = $0.50 2,000 = $1,000; After paying $1,000 in variable costs, $1,000 in revenue is left to apply toward total fixed costs. g. $0.40 (approximately) 3. i. If not already at its optimal level, adjust the usage of the fixed factor to its optimal level for the chosen output. ii. Exit the industry. Option (i) will be undertaken if adjusting capital usage reduces total cost below revenue. Option (ii) will be undertaken if adjusting capital usage cannot eliminate losses in the long run. 238

20 4. In the long run, P = LMC = minimum LAC. Not only is price so low that economic profit is zero, but per unit costs are at the lowest possible level, which implies that total costs are minimized for the competitive industry output. 5. Columns 1 8 in your table should look like this: (1) (2) (3) (4) (5) (6) (7) (8) Units of Labor Output Marginal Marginal Revenue Average Average Revenue Marginal Cost Profit when TFC = $ xx xx xx xx xx xx 128 a. 3 units of labor; 10 th b. increases; total; $70; decreases; total; $196 c. 9 units of labor maximizes total revenue (but not profit); $896 = TR L = 9 = ARP 9 = = P Q = As long as MRP is positive for an extra unit of labor, hiring that extra unit of labor will increase total revenue. d. 8 units of labor maximizes profit. This is the last level for which MRP > w. ARP L = 8 = $110.18; greater e. falls; rises f. 63; MR (or P); SMC; MRP; w g. $ a. $9; $0 In long-run competitive equilibrium, price is bid down to the minimum LAC of the typical firm in the industry. In this problem, the equilibrium price is $9, which means the typical firm has a minimum LAC of $9 and earns zero economic profit at a price of $9. b. $1,500 [= ($9 $6) 500]. If price is $9, the textile firm in this problem will produce up to the point where its LMC equals $9. This occurs at 500 units of output. The average cost to this superior textile producer is $6 per unit (at 500 units of output). So while the typical firm in the industry is earning zero economic profit in long-run equilibrium, this firm with the superior manager is able to earn $1,500 of economic profit per month by producing 500 units at a per unit cost of only $6 ($3 less than the typical firm). 239

21 c. $6,000 per month. Since the superior manager generates $1,500 of economic profit, other firms will try to hire this manager. As they compete to hire her, they will be willing to pay up to $1,500 more than the typical salary of $4,500. This superior manager, if she negotiates well, should be able to earn $4,500 + $1,500 = $6,000 per month. d. As owner of the firm, she would earn zero economic profit (that is, she would pay herself $6,000 per month salary since that is what she could make if she sold her business and went to work for some other firm in the industry). She does, however, earn a salary of $4,500 plus economic rent of $1, a. Q = 60,000 10,000P ; Q d s = 10,000P Solve for P 2011 = $3 Q ˆ = b 2 c = ( ) = 1, 500 units b. min c. ˆ (1, 500) (1, 500) 2 AVC = + = $0.975 (97.5 cents) min d. P = $3 > $0.975 = AVC min produce e. SMC = Q f. Set P = SMC and solve for Q * : * 3 = Q Q = 0 Q( Q) = Either Q = 0 or Q = 2,000. Since the firm should produce and not shut down the optimal output is Q * = 2,000 g. TR = P Q = $3 2,000 = $6,000 2 TVC = $2, 400 = AVC Q = (2, 000) (2, 000) (2, 000) ; Profit = $6, 000 $2, 400 $1, 600 = $2, 000 h. Set P = SMC again and solve for Q * : * * Q Q = * ( ) + ( ) 4(1.5)( ) Q = 1,667 = 2( ) i. TR = P Q = $1.50 1,667 = $2,500 2 TVC = $1, 667 = AVC Q = (1, 667) (1, 667) ( 1,667) ; Profit = $2, 500 $1, 667 $1, 600 = $ a. 400; $900 Q 170,000 = $190,000 Q = 400. b. $900; The slope of TC at the profit-maximizing point equals the slope of TR, and the slope of TR is P. c. $900; The slope of TR is P (= $900). d. $360,000; TR = P Q = $ = $360,000. e. $562,500; TC = ATC Q = $ = $562,500. f. $142,500; At 250 units, the profit margin (or average profit) is $570 (= $900 $330) profit = $

22 g. $50,000; At Q = 0, profit = TFC. At 250 units, ATC = $330 and AVC = $130, so TFC = ($330 $130) 250. h. $570; The 250 th unit adds $900 to total revenue and adds $330 to total cost, and so increases profit by $570 (= $900 $330). Thus, the slope of the profit function must be $570 at 250 units. i. $425; ATC = TC/Q ATC = $170,000/400 ATC = $425. i. 60; Since P = ATC at j, it is a break-even point. In the top panel, the break-even point occurs at 60 units. k. $820; Since TFC = $50,000 (see part g), it follows that ($900 AVC) 625 = $50,000. Solving for AVC AVC = $ a. At 250 units, AFC is $200 (= $330 $130), and at 650 units, AFC is $80 (=$900 $820). At 250 units, TFC is $50,000 (= $ ), and at 650 units, TFC is $50,000 (=$80 625). As Q increases, AFC declines continuously while TFC is constant. b. Break-even points occur at 60 and 625 units of output. At 60 units, the line tangent to TC is flatter than TR. Thus, in the bottom panel of the figure in Study Problem 8, SMC (which is the value of the slope of the line tangent to TC at 60 units) must be less than MR (which is the slope of TR and equals P). At 650 units, the line tangent to TC is steeper than TR. At 650 units, SMC (which is the value of the slope of the line tangent to TC at 650 units) must be greater than MR. c. At 400 units, profit reaches its maximum value because the slope of TR equals the slope of TC (i.e., MR = SMC). Since the 400 th unit adds $900 to TR and adds $900 to TC, the change in profit is zero and the tangent line has zero slope at the peak of the profit hill. d. Profit margin (or average profit) is maximized where ATC is minimized, which occurs at 250 units in this problem. By increasing output from 250 to 400 units, the firm can increase its profit by $47,500 (= $190,000 $142,500). e. Your response: Yes, increasing production to 500 units will indeed increase revenues by $90,000. Unfortunately, total costs will increase by more than $90,000 because marginal cost exceeds $900 (i.e., MR) for all of these 100 extra units. Thus, increasing output from 400 to 500 units will decrease profit. MULTIPLE CHOICE / TRUE-FALSE 1. a Perfectly competitive firms do not view each other as fierce rivals because each firm is so small relative to the total market that no one firm s increase in sales prevents any other firm from selling as much as it wishes to at the going market price. 2. a When demand is horizontal, P = MR, and demand is perfectly elastic. 3. d TR < TVC P < AVC shut down and MRP > ARP shut down 4. c Choice c is really P > AVC in disguise since TR/Q = P. 5. d Since ATC = 30 and AFC = 5, AVC must be 25. You are told that SMC = 25, so the firm must be producing at the minimum point on AVC. Since P = 24 < AVC min, the firm should shut down. 6. e In long-run competitive equilibrium, P = LMC = LAC = SMC = ATC, and profit = e MRP L=3 = MP L=3 P = 18 $2 = $36 8. d MRP L=7 = $24 > $22 > MRP L=8 = $20 9. d MRP L=6 = $28 > $26 > MRP L=7 = $24 241

23 10. a At the level of labor usage for which MRP = $40 (i.e., L = 2), MRP L=2 = 40 > 30 = ARP L = 2 shut down 11. b P = SMC = $70 at Q = 1, c $20,000 = ( P ATC) Q = (70 50)1, d SMC = P = $40 at Q = c $7,000 = ( P ATC) Q = (40 50) d Minimum AVC = $ e P = SMC = $40 at Q = 5, a $75,000 = ( P LAC) Q = (40 25)5, b Price falls because new firms enter and increase supply. 19. c Minimum LAC equals $20; 3, e P = P P = $ c Qˆ = bˆ 2cˆ = 400 = (0.08) min 22. d 23. d AVC ˆ = $44 = (400) (400) min SMC = Q + Q = Q = 2 * $ d AVC ˆ = = $45 = (500) (500) Q b Profit = ($55 500) ($45 500) $2,500 = $2, c P = P P = $ a P < AVC ˆ = $45 shut down min 28. b Profit = TFC = $2, F It is variable costs that must be covered in order to produce. 30. F Increasing fixed cost does decrease profit. The level of fixed cost does not affect the production decision. If P < AVC, the firm shuts down no matter how high or low fixed costs are. If P AVC, the firm produces the level of output where MR = SMC, no matter how high or low fixed costs are. 31. T A constant-cost industry has a horizontal long-run industry supply curve. In the long-run, an increase in demand will not lead to an increase in price. [Note: In the short-run, the short-run industry supply curve is upward sloping, even for a constant cost industry, and an increase in demand will cause price to rise in the short run.] 32. T Entry takes place when economic profits are positive and entry increases supply. 33. F The owner will earn a normal profit plus rent. 34. F Produce more if P > SMC 2 242

24 Homework Exercises 1. Consider the cost curves for a price-taking firm in the following figure: a. When price is $12 per unit of output, the firm maximizes profit by producing units. b. Since average total cost = $ for this output, total cost is $. c. The firm makes an economic profit (loss) of $. d. Price falls to $8. The firm now maximizes profit by producing units. e. At this output level, total revenue = $ and total cost = $. Therefore the firm earns a profit (loss) of $. f. Price falls to $6. The firm now maximizes profit by producing units. g. At this output level, average total cost is $ and total cost is $. Total revenue = $ and the firm makes a loss of $. h. Even though the firm makes a loss, it does not shut down because total variable cost is $, which leaves $ of total revenue to apply toward fixed costs. i. If price falls below $, the firm shuts down. Explain why. 243

25 2. Ajax Corporation is a price-taking firm in a competitive industry that employs only one variable input, labor, to produce a product that sells for $2 per unit. The wage rate is $8 per unit of labor and total fixed costs are $1,000. Fill in the blanks in each column of this table as instructed by the questions below: (1) (2) (3) (4) (5) (6) (7) (8) Units of Labor Output Marginal Marginal Revenue Average Average Revenue Marginal Cost Profit 0 0 xx xx xx xx xx , , , , , ,364 a. Fill in the blanks in columns 3 and 5. Marginal product begins to diminish beyond units of labor. Marginal product is negative beyond units of labor. b. Compute marginal and average revenue products and fill in the blanks in columns 4 and 6. The sixth unit of labor (increases, decreases) total revenue by $. Decreasing labor usage from four to three units (increases, decreases) total revenue by $. c. The manager can maximize total revenue by hiring units of labor. The maximum possible value of total revenue is $. d. The manager hires units of labor and produces units of output in order to maximize profit. At this level of labor usage, ARP = which is (greater, less) than MRP. e. Compute marginal cost and fill in the blanks in column 7. At first, marginal cost (rises, falls) as marginal product rises, then marginal cost (rises, falls) as marginal product falls. f. The profit-maximizing level of output is units because this is the last level of output for which exceeds, or equivalently, exceeds. 244

26 g. Compute profit and fill in the blanks in column 8. The optimal level of labor employment and the optimal level of output both result in an identical maximum profit level of $. h. Now suppose total fixed cost increases to $5,000. Recalculate profit at each level of labor usage (and output) and fill in the blanks in column 9 below. When total fixed cost is $5,000, the optimal level of labor usage is units of labor, and the optimal level of output is units. How high must total fixed costs rise in order for it to be optimal for this firm to shut down? Explain briefly. (1) (2) (9) Units of Labor Output Profit TFC = $5, , , , , , , Sunnyvale Orchards is one of many small, perfectly competitive firms growing apples for the U.S. market. The forecasted price of apples in 2012 is $23.60 per crate. The management of Sunnyvale Orchards estimates its short-run average variable cost function to be AVC = Q Q where Q is the number of crates of apples produced each week. Total fixed cost at Sunnyvale Orchards is $1,200 per week. a. Average variable cost reaches its minimum value at crates of apples per week. b. The minimum value of average variable cost is $ per crate. c. Sunnyvale faces the marginal cost function SMC = d. Sunnyvale will maximize profit (or minimize loss) by producing crates of apples per week in

27 e. Sunnyvale s profit will be $ per week. [Note: If a loss occurs, then express profit as a negative value.] f. If the price of apples falls to $10 per crate, Sunnyvale should produce crates per week, and its profit will be $ per week. [Note: If a loss occurs, then express profit as a negative value.] 4. The figure below shows a long-run industry supply curve (S LR ) and the demand curve (D) facing the competitive industry. The firms in this industry employ inputs of varying quality and productivity. a. The long-run marginal cost of producing the 20,000th unit of output is $. b. If the firms in this industry produce a total industry output of 20,000 units, every firm produces at the minimum long-run average cost of $ per unit and earns $ of economic profit. c. In long-run competitive equilibrium, the industry will produce units of the good and sell these units at the market-clearing price of $. d. The long-run marginal cost at the equilibrium output in part c is $, and the long-run average cost at the equilibrium output is $. e. The firms employing the superior inputs have lower costs than their rivals, but they still cannot earn any profit. True or false? Explain. f. Total producer surplus in long-run competitive equilibrium is $ for this industry. g. Who gets the producer surplus that you calculated in part f? Explain briefly. 246

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